The First Cut: Declining Total Assets and Positive Earnings Surprises

by John Bajkowski

Does it pay to focus on stocks with the greatest annual decline in total assets?

While it may be counter-intuitive, a recent research paper suggests that as a group, stocks with the largest increases in total assets underperform stocks with the lowest growth (or greatest decline) in total assets. This suggests that investors tend to overpay for past growth, creating mispriced stocks, while corporate managers tend to overpay to continue company growthespecially when pursuing mergers and acquisitions.

This issues First Cut is composed of domestic exchange-listed firms with the greatest single year decline in total assets. Financial stocks and utilities were excluded.

Assets can decline for a number of reasons: spin-offs, write down of assets, inventory reduction, dividend payments, etc. However, in the study, changes in non-cash operating assets (accounts receivable, inventory, and net property plant and equipment) had a very strong impact on return. Therefore, the First Cut screen also required an annual reduction in operating assets.

Earnings surprises were shown to have a strong, positive impact on stocks with low asset growth, so the First Cut looked for stocks with a positive earnings surprise (announced earnings above the consensus estimate) and at least one upward revision in expected earnings for the current fiscal year.

The inverse relationship between asset growth and subsequent stock performance was found to hold true across all sizes of companies; however, it was especially strong with smaller-cap stocks. The First Cut did not screen for company size, but the table below lists the market cap.

The 52-week price change highlights the weak stock price performance of most of these stocks. As with all contrarian strategies, one hopes that the market may have pushed down the value of these stocks below their true worth.

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In This Issue

April 2008 Issue

FeaturesPeerless Performers: The Top Funds Over 5 YearsTo be rated tops, a mutual fund must beat a benchmark, and the crucial benchmark is peer group performance over five years. Who are the current top performers, and how did they outperform their peers? A look at the top funds and how they managed to distinguish themselves.

Stock StrategiesThe Role of Diversification in an Individual Stock PortfolioA large number of holdings makes it impossible for investors to know their companies well. At the other extreme, holding just a handful of stocks can subject you to unnecessary risk and also impairs your ability to make rational decisions under pressure. Managing these emotional realities is one of the more subjective aspects of risk management through diversification.

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